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Habitat Magazine July/August 2020 free digital issue

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DEBT SWAP

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Debt Swap

Feb 03, 2020

Are there any funding tricks for a board facing a huge capital project? Tom Smith, managing partner at Smith, Buss & Jacobs, explains the details to Habitat.

Lots of buildings are facing huge capital projects, and the question facing boards is how to finance them. Are there any funding tricks that any of your clients have used?

One of them is something called a debt swap, and it's less scary than the name sounds. Our client, a 375-unit building in the Central Park area, has about 200,000 square feet of professional and commercial space that is subject to a master lease the former sponsor holds. It had approximately $15 million of mortgage debt. Going through the capital plan and looking at the various projects that were required, they were going to need another $17 million.

Whoa. That's more than their underlying mortgage.

Yes. The challenge was to get the money without having a massive impact on maintenance charges. They found a new lender and refinanced their underlying mortgage and consolidated it with the $17 million they needed for their projects. The lender agreed to advance those funds in stages as the work neared completion, even though the rate was locked at closing. By not having to pay interest on the portions that were being advanced later, they reduced the effective interest rate on their loan from 3.07 percent per annum for 10 years to 2.98 percent. Because of the extraordinarily low rate, they actually were able to refinance with no impact on their maintenance charges.

So what's the debt swap? How did that come into play?

A debt swap is a product where you take your adjustable rate loan and then bring in an investor who swaps that loan for a fixed-rate one, higher than the adjustable rate but lower than a market fixed rate.

And what does the investor pay?

The investor pays the lower swap interest rate under the fluctuating terms of the mortgage with the lender. The investor is taking a risk that the fluctuating rate that they've swapped into is going to go above the fixed rate that they've agreed to accept from the co-op for the term of the loan. Until that happens, if it happens, they're generating income on the spread.

Why would a co-op do this?

Primarily to get a lower rate than what they could on a standard fixed rate. If this co-op had refinanced conventionally with a fixed-rate 10-year product, the rate at that time would have been about 4 percent compared with the effective 2.98 percent rate they got in the deal.

Are debt swaps common?

They’re becoming more so. Prior to this transaction, some of our commercial real estate clients had utilized them, but none of the 350 or so co-ops and condos we represent had taken advantage of it. Being familiar with debt swaps was helpful in making the board comfortable with the idea.

It must have required some sophistication to understand this.

This is a board with CEOs, board chairmen and highly successful professionals. The positive part of that is the sophistication level. The less positive aspect is the strong opinions on which direction and which strategy to adopt.

Did they have to go back to the shareholders and explain the debt swap or did they just forge ahead?

They had the legal authority to enter into the agreement without a shareholder vote. But this board recognized the importance of informing and explaining it to the shareholders. They held several information meetings and had the engineers, architects and representatives of the various contractors there to answer questions. They also paid particularly close attention to the logistics of the projects to minimize the impacts that it would have.

What projects were carried out?

They were able to simultaneously redecorate the hallways, restore and replace windows, upgrade the elevators and HVAC system, and install energy-efficient equipment – all in an amazingly short three years.

For other board members interested in debt swaps, what’s the minimum dollar amount for it to make sense?

At the time that we closed, the primary lenders were really only interested in very substantial loans like this one. However, since then I've had clients who have done swap financing for much less – under $10 million. It’s gaining in popularity and accessibility, so more co-ops are able to take advantage of it.

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